Netflix 2011: Price Increase and Subscriber Impact

Netflix in 2011 Overview

• Netflix's abrupt price increase negatively impacted subscriber numbers in 2011
• Subscriber growth halted after the July price increase announcement with subscriber loss of 3 million predicted for the physical DVD service
• Streaming subscribers were expected to remain flat or decline, which was particularly concerning for the long term streaming strategy
• Reed Hastings, Netflix founder and CEO, faced challenges after being named Fortune's Businessperson of the Year in 2010

Price Changes and Public Reaction

• Netflix announced in July 2011 that it would start separately charging $7.99 a month for its streaming video service and its DVD service
• Previously, streaming was a $2 add-on to the basic $7.99 DVD monthly charge for a one-DVD-at-a-time plan
• Customers wanting both services would have to pay $15.98 a month, doubling the cost for existing subscribers
• The public criticized the 60% price increase for the combined service, overshadowing the price reduction for new streaming-only consumers

Qwikster and Apology

• Hastings announced the DVD-by-mail service would be split into a separate business named Qwikster, with the online streaming business retaining the Netflix name
• On September 18, 2011, Hastings apologized for the lack of respect and humility in announcing the separation of DVD and streaming, as well as the price changes

The Future of Netflix

• Streaming and DVD-by-mail services had different cost structures and benefits that needed to be marketed differently and operate independently
• Thousands of consumers criticized the plan, causing Netflix's stock to slide from $300 to $77 by October
• By mid-October, Netflix reversed course and abandoned the breakup plan

U.S. Home Video Rental Market in the 1990s

• The home video market in the U.S. was fragmented and largely populated with "mom-and-pop" retail outlets
• Customers rented movies, primarily on VHS cassette, from retail locations for a specified time period, usually between two days and one week, and paid a fee of $3 to $4 per movie rented

Blockbuster's Rise and Strategy

• Blockbuster Inc. became the market leader by understanding that movie rentals were largely impulse decisions, focusing on quickly obtaining the newest releases
• New releases represented over 70% of total rentals
• Blockbuster's growth strategy revolved around opening new locations to expand geographic coverage and increase penetration in existing markets
• By 2006, Blockbuster had 5,194 U.S. locations, with 4,255 company-owned and the balance franchised
• Locations were chosen based on customer concentration and proximity to competition, focusing on high-visibility stores in heavily trafficked retail areas, proclaiming 70% of the U.S. population within a 10-minute drive of a Blockbuster

Blockbuster's Operations and Costs

• Blockbuster stores were staffed primarily with part-time employees, averaging 10 staff members per store plus one manager and occupancy and payroll represented a significant percentage of total costs
• Blockbuster outlets carried 2,500 different titles per store and a substantial portion of the shelf space was dedicated to hit movies, with the newest releases receiving the most prominent display
• Locations typically acquired 100 copies of a new release and made up an estimated 75%-80% of demand compared to 20%-25% for catalog releases

Movie Release Windows and Economics

• Movie studios made movies available for exhibition at different times depending on the distribution channel known as "release windows" and the first channel was home video on DVD and VHS
• This window lasted 45 days and excluded most other forms of non-theatrical movie distribution
• Blockbuster's business model depended on maximizing the days that a movie was out for rent with stores reluctant to stock large numbers of lesser-known and independent films due to inconsistent demand

Blockbuster's Revenue Streams

• Movies not returned to the renting location by the end of the specified rental period were subject to extended viewing fees, or “late fees,” which represented about 10% of revenues in 2004
• They also improved asset utilization by encouraging a timely return, costing Blockbuster incremental rental opportunities and reduced customer satisfaction, due to increased stockouts

Blockbuster's Economics and Profitability

• Blockbuster acquired approximately half its rental inventory under a purchase model; Blockbuster paid the studios $15-$18, rented it 9–10 times for $4 per rental, and resold the DVD for an average of $8 per unit
• Other half was acquired under a revenue share model where Blockbuster paid about $5 per copy, rented it 9 times, and resold it for an average of $8, sharing 30% of the revenue with the studios
• Retail stores cost approximately $300K to set up, and produced $900K sales per year with an operating profit of $162K

Netflix Origins

• Hastings conceived of Netflix in 1997 after paying a $40 late fee for an overdue rental of Apollo 13
• Hastings considered alternative ways to provide a better home movie service based on VHS videocassettes at the time, with a friend telling him about the new DVD technology
• He bought CDs and mailed them to himself to test the feasibility of inexpensive postal delivery

Initial Netflix Strategy

• Netflix was founded in 1997 and launched its first website in early 1998
• The company targeted early technology adopters who had recently purchased DVD players, offering cross-promotional programs with manufacturers and sellers
• Netflix's website had a search engine to sort through selections by title, actor, director, and genre, and customers could build a "queue" of movies to be received from Netflix
• Initially used a pricing model similar to that offered by traditional video stores where customers were charged $4 per movie rented plus a $2 shipping and handling charge

Netflix Marketing Shift

• Early strategy of Netflix went beyond DVD rentals to become the ultimate online destination for movie enthusiasts for everyone, with a recommendation system to non-subscribers
• The company shelved its plans for an IPO and struggled through a large layoff as it adjusted its business model to reach profitability, with a change in leadership to Neil Hunt

Prepaid Subscription Model

• Hastings thought moving to a prepaid subscription service would provide better value to Netflix's customers, turning longer delivery times into an advantage
• The first iteration of the subscription model allowed customers to have four movies in their possession at once and receive up to four new films each month
• Netflix soon changed its pricing system again, offering unlimited rentals for the first time where subscribers could now keep three movies at a time and exchange them as frequently as they liked

Evolving Customer Base

• With the Netflix change, the company added a new group of fans for whom movie rentals were a regular part of their daily entertainment, with Netflix offering an "all you can eat" model

Recommendations

• Initially relied on traditional merchandising where a small number of employees highlighted different films on the website's home page each week, effectively providing the same recommendations to all subscribers
• Netflix engineers developed a proprietary recommendation system to better balance customer demand upon establishing a new account for the first time, with a proprietary algorithm using survey results and the respective ratings of millions of similar customers to recommend films, also providing synopses, descriptions, and reviews from subscribers

Movie Library

• In 2006, Netflix initiated a competition, the Netflix Prize, which offered $1 million for the best collaborative filtering algorithm to improve its recommendation system, including 100 million ratings from 480,189 viewers

Library Management

• Netflix's inventory management included a filter placed between the output of the recommendation system and the results shown to the subscriber, screening for movies that were out of stock for the purposes of utilization of Netflix's library of films by satisfying customers with movies already acquired and in stock

Growth and Development

• Netflix gained improved customer satisfaction by eliminating "bait and switch" perception as rankings were three-fourths of a star higher on recommended movies, marking a cultural battle with those who had remained loyal to the traditional merchandising system,
• As a small player in the video rental market, Netflix had no direct relationships with the major studios and filled its film library through relationships with a small number of movie distributors, at prices that reflected minimal discounts
• Netflix hired Ted Sarandos as chief content officer to manage content acquisition to transition to revenue-sharing agreements with the major studios, rather than paying an upfront price of $18-$20 per DVD, reducing pricing in return for a fee based on number of title rentals

Netflix Distribution

• Netflix operated out of a single distribution center in Sunnyvale, California in 2001
• By the summer of 2001, they worked to upgrade Sacramento because they realized that regions with overnight delivery were being disproportionately successful
• Distribution center reach was increased by arranging with the U.S. Postal Service (USPS) to intercept returns at a Sacramento mail-sort center and truck them to Sunnyvale

Growth of Distrubution

• Netflix opened more distribution centers across the country, and subscriber numbers continued to respond to the improved delivery service, hitting 700,000 subscribers at the time of its May 2002 IPO
• The number of distribution centers reached 58 by early 2009, in which most of Netflix's 10.6 million subscribers could be reached within one delivery day, with employees opening and re-stuffing an average of 800 DVDs per hour
• Developed a strong relationship with the USPS, with the USPS bringing the easily recognizable red Netflix envelopes to the closest Netflix distribution center

Content Aquisition

• Content acquisition continued to grow in importance because their buying staff had to keep their finger on the pulse to make decisions, including 70% science and 30% art
• As Netflix built its film library, it grew in importance as a distribution channel for many small and independent film studios, representing between 60% and 75% of the earnings for some films, leading Netflix to begin acquiring distribution rights through its Red Envelope Entertainment subsidiary

Customer Retention

• In an average month in 2002, 6.3% of customers canceled their subscriptions
• Netflix changed its approach so that customers could unsubscribe online with a brief survey and Hastings believed it was more fruitful to try to encourage departing customers to return later than to try to coerce unwilling customers to stay

Strategies

• Netflix invested in things that were strategically relevant to customer satisfaction potential (like maintaining customer profiles) and Hastings found that growing the business in the face of a high churn rate was easier if many lost customers eventually returned

Blockbuster Response

• Blockbuster stated in May 2002, that they have “not seen a business model that's financially viable long-term in this arena” in reference to online retail services
• Blockbuster responded with Blockbuster Online in 2004 and characterized its entry as a "land grab," undercutting Netflix's pricing and distinguished itself by integrating its services with B&M stores
• Introduced Blockbuster Total Access in 2006, which allowed customers to exchange DVDs by mail or in a store; launched its “no late fees” program

Video on Demand ("VOD")

• Was considered the next trend but was limited until the technology to connect users TVs was more available and were unwilling consumers were unwilling to pay equivalent prices for viewing movies on their computers
• Studios were reluctant to offer much content given concerns with pirated downloads, with Netflix dealing "with the same problem as everyone else" in negotiating distrubution rigths

Streaming

• Hastings repeatedly stated that Netflix's purpose was to allow for the best home video viewing for its customers, that would build from existing brand power in its DVD-by-mail offerings

Licensing of Content

• The service hinged content, personalization, device attachment, and streaming infrastructure
• Netflix's first breakthrough streaming deal was with Starz Entertainment in 2008, that brought 2,500 titles from Walt Disney & Sony,
• Netflix signed a five-year deal worth nearly $1 billion so that they could continue differentiating themselves

Operations Today

• Members can take advantage of Netflix's considerable investments in its recommendation system to find relevant entertainment
• The company mounted an aggressive campaign to create a bridge from the Internet to the TV set, which would ultimately see their subscibers view a streaming subscription more than a DVD

AWS and Transcoding

• In 2009 Netflix migrated its transcoding applications to Amazon Web Services (AWS), and then in 2010 it migrated the streaming application
• The rapid growth of streaming relative to DVD-by-mail prompted Hastings to wonder, "How could he manage the transition from one business model to another?"

In 2011, Netflix faced challenges due to an abrupt price increase, negatively impacting subscriber numbers. The price change, which separated streaming and DVD services, led to public criticism and a projected loss of subscribers. This posed concerns for Netflix's long-term streaming strategy despite previous successes.